Lecture 9 : Private Equity

Alternative Investments Introduction

Let’s broaden the scope of the investable universe
- Private equity, hedge funds, fixed income and derivatives
Everything we learned in first half of class applies, but…
- Data is more opaque
- Liquidity is a bigger issue
- Institutional details matter more
  - E.g. Lock-up periods, redemption, fee structure
- Efficiency (maybe?)

What is Private Equity (PE)?
A PE fund is a financial intermediary typically formed as limited partnerships
- General Partner (GP): Manage funds, make investments
- Limited Partners (LPs): Passive investors (pension funds, endowments)
A PE fund invests only in private (or soon-to-be-private) companies
- Costs: information asymmetry and illiquidity
- Benefits: control

A PE fund takes an active role in the firm
- Added value through management/monitoring
A PE fund has an exit strategy
- Because of illquidity of investment, targets must provide a clear path to exit (e.g. IPO or sale to another company)
- Funds are closed-end with lifespans of 10-12 years
  - Commitments raised
  - Capital calls/investments made
  - “Harvesting” period

Screening:
- VCs as winner-pickers – select 1-in-400 deals to fund
- Do VCs bet the jockey or the horse?
- High management turnover suggests the horse
Advising/Monitoring:
- Requires control rights
- Investments typically include voting rights, board seats, esp. in bad times
Exit

Important to have good VCs for good returns!

Gompers et al 2020 find that:

When selecting deals, VCs place the greatest importance on the management team.
VCs devote substantial resources to deal sourcing, selection, and post-investment value-add.
Most VCs do not use discounted cash flow (DCF) or net present value (NPV) techniques to evaluate investments. They rely more on valuation multiples and IRR.
After investing, VCs are actively involved with their portfolio companies.
VCs are generally inflexible on key economic terms in contracts like liquidation preferences, anti-dilution rights and vesting.
VC firms are small, with only 14 employees on average, half of whom are senior investment professionals. Most of their time is spent on sourcing and working with portfolio companies.

In contrast to VC, (Leveraged) Buyout (BO) funds focus on established firms
Firms are either private to begin with, or are taken private (as in a management buyout)
Large amounts of new debt are used to finance the repurchase of existing equity
- Often 90/10 debt-to-equity ratio in new company
- Example: RJR Nabisco, Dell
There’s big demand: in 2020, LBO funds had 1.6 trillion dollars to spend on buyouts

Where does the value-add come from?
- No need to take company private to exploit an undervalued stock
- Similar to VC, control must matter
What types of things do LBO firms do once they have control that adds value?
- Spin-offs of conglomerates
  - Beatrice Foods
- Efficiency gains (cost-cutting, union negotiations, layoffs)
  - Safeway

Incentives of GPs and LPs may not always be aligned
GPs may have incentives to shirk or take excessive risk
Fees, co-investment by fund managers and covenants discipline GPs and protect the LPs
- Fees include a flat rate (1-3%) plus 20-30% performance fee
- Co-investment: General partners often required to personally invest in the funds (typically GP invests 1%)
- Covenants: e.g. restrictions on activities

Private equity is, by definition, private – limited trading with no continuously posted price. How can we evaluate the risk return profile?
At the minimum, we need to at least evaluate the different return levels
- Then, we need a way to evaluate riskiness
Two main (and limited) ways in private equity:
1. IRR (discounted cash flows)
2. multiples on investment
Multiples is the value out divided by the initial payment in \[ M = \frac{\sum_{t=1}^{T}C_{1}}{P_0}\]
IRR you know quite well – accounts for timing of cash flows (payments)

\[ 0 = P_{0} + \sum_{t=1}^{T}\frac{C_{t}}{(1+r)^{t}}\]

Table reports mean, median, standard deviations and 25-75th percentile of dollar weighted returns (IRR) to PE funds
- Why dollar-weighted returns?
- On average, roughly equivalent to S&P500 during same period (net of fees)

The comparable results to the market prompt a simple comparison:
- What is the return of the contribution to the fund if it had been put in the market?
This is the private market equivalent (PME): the funds placed into PE fund are evaluated based on the opportunity cost of missing out on the market
This approach can be much better than just IRR or multiples, since it will account for the opportunity cost relative to the market
- A rising tide lifts all boats
- Effectively adjusts payouts based on the return in market
- But… assumes a \(\beta\) of 1!
With PME, IRR, and multiples, can compare the relative return on investments (but not riskiness

These measures of PME, IRR and multiples give ways to evaluate PE funds
- This gives a history of returns for a given fund
How to evaluate riskiness? Two ways:
1. Consider the variance in the time series. Subject to serious data issues (selection bias)
2. Simulations – model capital calls / cash flows
Neither of these methods adjust for aggregate risk factors
- Gupta and Van Nieuwerburgh (2020) argue that PE is actually quite exposed to other factors
- Model the cash flows and compare to other public market factors
- Highly exposed to SMB, HML, and other public equities – suggestive you could get the same return by investing in public equities instead (at least on average)

How to identify good private equity funds?
Pick past winners!
Returns to private equity are highly persistent (Why?)
Issue: everyone wants to get in funds with strong performance
- Who gets access?
- What incentive effects does this create?

Often the binding constraint for successful PE funds is investment opportunities, not investors
Leads to money-chasing-deals phenomenon
During periods of high flows into private equity, funds pay higher valuations for their acquisitions